Throughout history it has been observed that financial institutions have often failed. Some of the most common reasons for this can be attributed to regulation, either lack of or too much. Risk is often cyclical in nature, when the market is in an upswing most financial institutions will increase their appetite for risk and when the market is in a downturn, financial institutions will cut back on lending and increase their reserves (Peretez et al, 2009, p.609). "Markets respond to changing conditions in search of increased profitability" (UOL Lecture Notes, 2011). Changing conditions thus support the foundation of financial innovation, in which many of these institutions seek to achieve the highest possible profits sometimes with inappropriate risk taking and total disregard for possible outcomes.
Why do Financial Firms Innovate and Maintain an Appetite for Risk? Banks are mainly regulated in order to protect the interest of its depositors (liabilities) and limit risk taking which is known as prudential regulation (Kohn, 2004, p.595). Because bank balance sheets are often mismatched short-term liabilities (deposit funds) against longer term assets (loans) it leaves the bank more open to adverse shocks such as bank runs. While banks are often covered by depositors insurance, this is not always effective in preventing a bank run because depositors will often react to what others are doing. Deposit insurance as well as lenders of last resorts such as Central Banks essentially allows depositors some reassurance; however this can also be an incentive for banks to engage in riskier behavior. While certain regulations have been put in place to deter risky behavior, evidence shows that many financial institutions have sought out ways to maneuver around regulations. This is most often in an attempt to enhance profitability through the creation of other types of assets. According to Calomiris (2009, p. 65) "financial innovations often respond to regulation by sidestepping regulatory restrictions that would otherwise limit activities in which people wish to engage". Banks are not the only financial intermediaries which are regulated. The securities market which involves institutional investors and arms length investors also require protection. The main reasons why these investors need protection are to guard against cheating and instability (Kohn, 2004, p. 637). Different countries have different regulation requirements. For example the UK and US use the 'Anglo' model which serves to "monitor and reinforce the market", and the 'Continental' model is moreover used by Europe and Asia which has a more direct influence and control over the market (UOL Lecture Notes, 2011). The most important determinant of banks and other financial intermediaries is the inherent liquidity risk issue. It is of utmost importance that liquidity risk is markedly monitored. Illiquidity for a financial institution poses a threat to its continued success. Lack of liquid resources ultimately leads to failure. There are two ways in which banks can manage liquidity risk, internal and external. Internal risk management entails the bank holding reserves as well as matching maturities and currency denominations of its assets and liabilities. External management involves the reliability of obtaining funding from outside resources while hedging with the use of derivatives to minimize risk (Kohn, 2004, p.603). There have been an incredible amount of arguments which relate to the regulations of these institutions in regards to their use and abuse of financial innovation. But a question arises? Is all financial innovation bad? Some say that financial innovation is a necessary component that can stimulate economic growth, but is widely dependent on how it is used and other's say it serves no purpose. For example according to Litan (n.d.) who cites Volcker's views on financial innovation who was a former Federal Reserve Board Chairman in the US, that there have been no other recent financial innovations that have contributed to the finance industry recently other than the ATM machine. He further notes that Volcker's reasoning for this could be attributed to economic development over time from the 1950's up to the 1980's where financial innovations such as CDS's and CDO's were of no importance to continued growth and stability of the economy. However according to Litan (n.d.), there are many other financial innovations which have been contributory to the growth of the economy which include, credit cards, debit cards, mobile banking, internet banking and a host of other examples. However, more recently 'bad financial innovations' as some would call it, such as CDS's and CDO's were largely blamed for the collapse of the US Housing Market or subprime crisis.
Conclusion: In conclusion, it seems very apparent to me that while some lay blame on certain financial innovations wreaking havoc which resulted in a global systemic crisis, it doesn't appear in itself that the financial innovations such as CDO's and CDS's were directly to be blamed, but rather the lack of regulation surrounding the issuance of such instruments. Perhaps if the government had intervened rather than turning a blind eye to something that was on the verge of being out of control by posing restrictions in a bid to tighten mortgage activity, the fall wouldn't have been as harsh, and there might have been less fall in asset values. From my point of view, financial innovations aren't really bad; it's how they are used. Last and but not least I conclude with a very interesting statement made by Litan (n.d.) who notes "what has been called 'regulatory dialectic' in finance - new rules aimed at preventing old abuses being circumvented by yet new innovations, and yes sometimes by new abuses - is as old as finance itself". Which leads me to believe that no matter how much one rehashes the ideas surrounding financial innovation, the fact remains that there will always be individuals and institutions who are seeking higher profits and thus find a way around those rules even if it entails risky behavior. In short rules and regulations can be in place, and new rules can replace old rules to accommodate new trends, but there will always be mistakes and aren't new rules made to amend those mistakes?